S&P - Public Finance Criteria (2007). - The Global Clearinghouse

General Government UtilitiesPoor’s view that operation and maintenance expensesmust be paid in order for a system to be a viable,ongoing concern that will generate revenues for debtservice, whether pledged on a net or gross-lien basis.Standard & Poor’s will review the security pledge toensure that ongoing revenues are available for debtservice payments. If the pledge allows prior periodrevenues through the use of a rate stabilization fundthen it is better that those revenues provide the revenuecushion stated in the rate covenant and thatrevenues derived from the operation of the utilityalone provide at least one times annual debt servicecoverage. If an issuer intends to use tap fees, systemdevelopment fees, or connection fees as part of thepledged revenue stream it is important that the systemhas at least sufficient coverage from operatingrevenues alone. If operating revenues are insufficientit may be necessary to demonstrate that operatingrevenues are intended to cover annual debt servicewithin a few years.While the typical senior-lien pledge of an enterprise’snet revenues is considered to be the mostsecure, junior-lien debt need not always be ratedbelow senior obligations. In cases where the seniorlien has been legally closed and the creditworthinessof the issuer supports the higher rating, an argumentcan be made to rate both the senior lien andsubordinate lien at the same level. Also, if an issuerhas a proportionately smaller amount of senior liendebt versus subordinate lien debt and if the generalcreditworthiness of the issuer warrants it then thetwo liens can be rated on par.Finally, in some cases the general creditworthinessof the issuer is strong enough to allow the seniorand subordinate debt to be rated on par. Manyissuers have set internal policies to operate thewater and/or sewer systems at coverage levels wellabove the rate covenant to generate sufficient revenuesto fund a large portion of the capitalimprovement plan. When an issuer consistentlyoperates in excess of the legal rate covenants ofboth the senior and subordinate debt, this couldjustify the support of equivalent ratings.Rate covenantsThe rate covenant, actual coverage, and the abilityto raise rates are factors that provide credit strengthto water and sewer utility revenue bonds. Withmost utility financing, the rate covenant requiresmanagement to set rates for service that will generatenet revenues sufficient to provide a defined minimumlevel of debt service coverage—typically1.10x to 1.20x. While this range is the norm, ratecovenants as low as 1x are acceptable in situationswith limited operating risk. While a 1x (sufficiency)rate covenant would be acceptable, Standard &Poor’s expects to see higher levels of coverage inmost years. The covenanted level is the minimumlevel and is considered the exception rather than therule over the long term.Again, the definition of revenues providing thecoverage is as important as the covenanted level ofrequired coverage. Generally, recurring revenuesfrom operations should be sufficient to cover debtservice, and only such revenues should be defined as“net revenues”. Cash balances and nonoperating ornonrecurring revenues such as developer fees, systemdevelopment charges, and connection fees are sometimesincluded, but cause additional concerns. Often,these resources are available for use only once, anddepletion of those resources can put significant pressureon rates. Although “rolling coverage” is becomingincreasingly common, operating revenues shouldtypically cover operating costs and Standard &Poor’s will analyze coverage calculations both withand without non-operating revenues.Additional bonds testsThe additional bonds test ensures existing bondholdersthat a minimum level of coverage has beenmet upon the issuance of additional parity debt.Standard & Poor’s focuses on whether the issuer’sright to offer senior or parity bonds at a later timecould result in a dilution of coverage. A conservativeadditional bonds test requires that net revenuesfor a prior fiscal period (the previous fiscal year or12 consecutive months) equal at least 125% of themaximum annual debt service requirement, takinginto account the issuance of proposed bonds. A testthat measures historical earnings is stronger becauseit is less speculative than those based on revenueprojections. Often, projected tests rely on assumptionsthat may not be realized, such as future rateincreases or revenues generated by new facilities.Adjustments to historical net revenues to reflectnew customers or rate increases, which have beenimplemented prior to the proposed bond issuance,are common and acceptable. While a conservativeABT helps mitigate future bondholder risk,Standard & Poor’s also takes into account thescope of the capital program and related risks andimpact on a system’s financial profile.Flow of funds—transfers outThe flow of funds specifies the order and timing inwhich system revenues are used to meet the obligationscreated by the indenture. Of critical importanceto the rating is the lien position of debtservice payments in relation to other system obligationsoutside of ordinary operations and maintenancecosts. Also, Standard & Poor’s looks forestablished reserve funds, such as debt servicereserve and renewal and replacement accounts to befunded in turn, to provide additional cushion for118 Standard & Poor’s Public Finance Criteria 2007